Cost of Capital and profitability analysis (a

Case study of
teleCommuniCation industry)
asha sharma*

Abstract Finance is the supply of funds, which regulates the activities and operations of the industry.
Adequate finance is required besides the requirement of fixed and working capital for undertaking the program of
extension, reorganization or expansion. Finance regulates the activities and operations of the industry. Adequate
finance is required besides the requirement of fixed and working capital for undertaking the program of extension,
reorganization or expansion. There are various source of raising funds. Since, now-a-days market is open, so both
domestic and international market are available for procuring the funds. Finance is being raised through issue of
shares, debenture, bond and retained earnings (internal source) from domestic as well as international capital
market in the form of Global Deposit Receipts, American Deposit Receipts and Foreign Currency Convertible Bonds
and from the wide range of financial institutions. However, the finance is not free of cost. The charge on each
source capital is known as cost of capital. The cost of capital of any investment is the rate of return the
suppliers of capital would expect to receive if the capital were invested elsewhere in an investment of comparable
risk.
The present study focuses on whether cost of capital has any relationship with financial performance of companies
like capital structure. To know about the relationship between cost of capital and income generation capacity of a
company, gross profit ratio is not sufficient. If cost of capital is not taken care properly, if it is more than
returns, company can reach to crucial financial situation. So an effort has been made to measure impact of cost
of capital on various financial factors i. e., profitability, growth rate, liquidity and dividend policy. The statistical
like correlation and regression method have been applied. The study found that change of cost of capital affects
the company’s profitability position. The higher cost of capital adversely affects the profitability position of the
companies.

Keyword: Cost of Capital, Return, Growth Rate, Liquidity, Performance, Profitability

The Indian economy has witnessed robust growth in the last
few years and is expected to be one of the fastest growing
economies in the coming years. Demand for commercial
property is being driven by India’s economic growth. Real
estate in India contributes about 5 per cent to India’s gross
domestic product (GDP). The total revenue generated in
2010-11 stood at US$ 66.8 billion. India’s Information
Technology (IT) and Information Technology enabled
Services (ITeS) segments are aligned in a way that the
growth in one avenue has ripple effects on another. The IT &
ITeS industry, as a whole, is the mainstay of Indian
Technology sector as it has driven growth of the economy in
terms of employment, revenue generation, standards of
living etc and has played a major part in placing the country
on the global canvas.
The project’s cost of capital is the minimum required rate of
return on funds committed to the project, which depends on
the risk of its cash flows. The firm’s cost of capital will be
the overall, or average, required rate of return on the
aggregate of investment projects. It is a concept of vital
importance in the financial decision-making. It is useful as a
standard for:
1. Evaluating investment decisions
2. Designing a firm’s debt policy 3. Appraising the
financial performance of top management
The firm’s cost of capital is the rate of return required by
them for supplying capital for financing the firm’s
investment projects by purchasing various securities. It may
be emphasized that the rate of return required by all investors
will be an overall rate of return – a weighted rate of return.
Thus, the firm’s cost of capital is the ‘average’ of the
opportunity costs (or required rates of return) of various
securities, which have claims on the firm’s assets. This rate
reflects both the business (operating) risk and the financial
risk resulting from debt capital.
reVieW of literature
A comprehensive review of literature in respect of the
parameters pertaining to financial performance, determinants

*Assistant Professor, Department of Commerce, Mahila Mahavidhalaya, J. N. V. University, Jodhpur

 Cost of Capital And Profitability Analysis (A Case Study of Telecommunication Industry) 43
of capital structure and interrelationship between cost of
capital and companies’ performance both in the domestic and
international level was carried out. The major observations
are summarized as under: Cost of capital declines with
leverage due to the tax deductibility of interest charges,
(Modigliani and Miller, 1962). The cost of capital is affected
by debt apart from its tax advantages (Sarma and Rao, 1968).
Age, retained earnings, and profitability were negatively
correlated while total assets and capital intensity was
positively related to debt- equity ratio (Chakroborty, 1977).
Cost of capital of
Indian firms increased from 7.36 percent to 12.36 percent
over years. The average cost of capital for all consumer
goods industry firms taken together was the highest while; it
was lowest for the firms of intermediate goods (Chakroborty,
1977). There is an impact of size, growth, business risk,
dividend policy, profitability, debt service capacity and the
degree of operating leverage on the leverage ratio of the firm
(Bhat, 1980). The weighted average cost of capital of a
company will fall with the increased borrowing until a point
is reached where the higher cost of share and loan capital
force the average up. The optimum-earning ratio is achieved
only when the weighted average cost of capital is at the
lowest point (Knott, 1991). The cost of capital is playing
significant role for determining the capital structure of multi
National Corporation also. The multinational corporation is
assumed to finance its foreign subsidiaries in such a way as
to minimize its incremental weighted cost of capital (Bhalla,
2000). The firms are mainly concerned about financial
flexibility and credit ratings when issuing debt and per share
dilution and recent stock appreciation when issuing equity.
The most firms have target debt-equity and issue-equity to
maintain a target-debt ratio (Graham and Harvey, 2001). A
project that requires highly specific assets would initially be
financed by equity. However, as the debt to equity ratio
decreases in line with agency theory, the demand for debt
falls and equity rises (Vialasuso and Minkler, 2001). Cost of
capital is a central concept in financial management linking
both investment and financing decision. The Indian
companies faced a high relative cost of capital as compared
to their international counterparts (Chadha, 2003). The
foregoing studies attempted to examine the relationship
between cost of capital and companies performance. In most
of the studies it is been seen, emphasis is given on effects of
capital structure on cost of capital and on determinant of
capital structure. However, no serious and systematic efforts
have been made by the researcher in regard to relationship
between cost of capital and companies financial
performance.
Company profile
Bharti Airtel Limited is a leading integrated
telecommunications company with operations in 20
countries across Asia and Africa. Headquartered in New
Delhi, India, the company ranks amongst the top 5 mobile
service providers globally in terms of subscribers. In India,
the company’s product offer-
ings include 2G, 3G and 4G services, fixed line, high speed
broadband through DSL, IPTV, DTH, enterprise services
including national & international long distance services to
carriers. In the rest of the geographies, it offers 2G, 3G
mobile services. Bharti Airtel had over 246 million
customers across its operations at the end of February 2012.
metHodoloGy
The purpose of the research is to study the relationship
between various ratios to know the impact of cost of capital
on profit, growth, investment decision and dividend decision
in Indian industries. Further, this paper is an effort to know
about how to frame an optimum capital structure.
obJeCtiVes of tHe study
The objective of the study is to examine the relationship
between the working capital management efficiency and
profitability of the Telecommunication industry in India.
The following are the specific objectives:
• To analyze interrelationship and impact of Cost of
capital on various variables determining companies
performance
• To analyze the relationship between cost of capital
efficiency and profitability of selected industries in
India.
data set & sample
The data used in this study was acquired from companies’
website for a period of six years from 2005 to 2010. The
study is based on secondary data. The data mainly collected
from Capitalline, website entitled to www.indiainfoline. com
and annual reports of companies has also been used. To
analyze the data financial as well as statistical tools has been
used. The financial tools like ratio analysis and statistical
tools such as average, correlation coefficient and regressions
were used. The statistical results were verified by applying t-
test, F-test, Z-test in appropriate cases
HypotHesis testinG
Since the objective of this study is to examine co-relevancy
between gross working capital to other variables like fixed
assets, total assets and sales. For this a set of testable
44 Journal of Commerce & Accounting Research Volume 1 Issue 4 October 2012

hypotheses (the null hypothesis H0 versus the Alternatives Hypothesis 3

ones H1) is decided and proved by correlation analysis
H01: There is significant relationship between the cost of
researCH HypotHeses capital and dividend

Table 1: Calculation of cost of capital in Bharti Airtel

Bharti Airtel
Year EPS DPS BV MV ROE EY DY Payout
Rs. in million %
Mar-05 6.53 2 38.71 276 20.74 0.27 0.007 0.306
Mar-06 10.62 3 68.19 238 29.06 0.31 0.013 0.282
Mar-07 21.27 2 89.74 234 27.95 0.36 0.009 0.094
Mar-08 32.56 2 106.19 263 28.4 0.38 0.008 0.061
Mar-09 40.7 4 145.19 298 23.66 0.17 0.013 0.098
Mar-10 24.82 3.5 96.24 300 30.19 0.34 0.012 0.141
Average 10.7417 2.75 90.71 268.17 26.67 0.12 0.010 0.256
ROE = EPSX No. Of Share/ Net Worth
Net worth= equity capital+ Retained Earning
BY= Book Value
MY= Market Value
EY= Earning yield
DY=Dividend Yield
retaintion cost of cost of Current Profit after
Year ratio equity growth capital Ratio tax

Mar-05 0.69 18.83239 29.89673 48.7291 0.44 1,210.67

Mar-06 0.72 14.10437 40.50094 54.6053 0.47 2,012.08
Mar-07 0.91 6.142506 30.85088 36.9934 0.57 4033.23
Mar-08 0.94 4.914005 30.25864 35.1726 0.69 6,940.37
Mar-09 0.90 16.11604 26.23875 42.3548 0.7 8,134.67
Mar-10 0.86 32.5834 35.14614 67.7295 0.7 10,703.53
Average 0.84 15.45 32.15 47.60 0.60 5505.76

Hypothesis 1 H11: There is negative relationship between the cost of

capital and dividend
H01: There is significant relationship between the cost of
capital and profitability
Hypothesis 4
H11: There is negative relationship between the cost of
capital and profitability H01: There is significant relationship between the cost of
capital and growth
Hypothesis 2 H11: There is negative relationship between the cost of
capital and growth Telecommunication Industry
H01: There is significant relationship between the cost of
capital and liquidity
H11: There is negative relationship between the cost of
capital and liquidity
 Cost of Capital And Profitability Analysis (A Case Study of Telecommunication Industry) 45

Bharti Airtel
Calculation of Growth Rate

Year EPS Growth DPS Growth

Mar-05 10.62 2 1 0.50
Mar-06 21.27 10.65 1.00 3 -1 -0.33
Mar-07 32.9 11.63 0.55 2 0 0.00
Mar-08 40.7 0.52 0.02 2 2 1.00
Mar-09 24.82 -15.88 -0.39 4 -0.5 -0.13
Mar-10 32.56 7.74 0.31 3.5 7.5 2.14
Average 27.145 2.44 0.25 2.75 1.5 0.53
Cost of Equity
ROE x Retaintion ratio Cost of equity DPS/MP*100+G
Based on retaintion ratio
23.98 26.67*0.899 1.025+23.98 25.00
Based on EPS 25.00 1.025+3 26.03
Based on DPS 27.00 1.025+15 28.03
Cost of Debt
12% Debanture 7.92 12*(1-0.34)
Weighted Average Cost of Capital

Weight WACC
Sources of capital Cost of capital
Book Value Market Value Book Value Market Value
Debt 7.92 0.62 0.36 4.91 2.85
Equity 28.03 0.38 0.64 10.65 17.94
Total 35.95 1.00 1.00 15.56 20.79
Bharti Airtel Capital Structure, 2009-10

Sources of capital book value weight market value weight

Debt 33458 0.62 33458 0.36
Equity 20276 0.38 59678 0.64
Total Capital 53734 1.00 93136 1

metHodoloGy of Computation Cost of ROE = EPSX No. Of Share/ Net Worth

Capital Net worth= equity capital+ Retained Earning

Following are the steps that are used in evaluating the Cost
of capital for the companies taken for study. Dividend Price
method is applied to evaluate cost of equity. Cost of Equity
(Ke ) = (DPS/ MPS)+ Growth of EPS Where, EPS= Earning
per Share, MPS= Market price per share
The Cost of Equity of both sample companies as a whole
pertaining to individual year has been calculated at first and
then simple average of the same has been taken.
Then, their respective proportions in the capital structure are
multiplied by these costs of sources. The book value weight
of each source of finance used in calculating cost of capital
because in practice. The book value weight and market value
both the methods are used to calculate weighted average cost
of capital.
BY= Book Value
MY= Market Value
EY= EPS/MPS
DY=DPS/MPS
Payout=DPS/EPS
Retaintion ratio=1-Payout
A firm’s WACC is the overall required return on the firm as
a whole and, as such, it is often used internally by company
directors to determine the economic feasibility of
expansionary opportunities and mergers. It is the appropriate
discount rate to use for cash flows with risk that is similar to
that of the overall firm
Weighted Average Cost of capital (cost of capital) =
Where, V= (equity capital+ debt capital+ retained earnings),
Ke= cost of equity, Kd= Cost of debt capital, Kr= cost of
46 Journal of Commerce & Accounting Research Volume 1 Issue 4 October 2012

retained earnings, E= equity capital, D= debt capital R=
retained earnings.
CONCEPTUAL FRAMEWORK
(VARIABLES OF MEASURING
COMPANIES’ PERFORMANCE)
Profitability: Profitability implies profit-earning capability
of business unit. Return on Equity ( ROE ) is considered to
measure profitability of the concern.
Liquidity: Liquidity refers to the ability of a concern to meet
its current obligation.
Current ratio has been included in the models. It is calculated
by dividing current assets by current liabilities.
Dividend pay out ratio: - It measures the relationship
between the earnings belonging to the ordinary shareholders
and the dividend paid to them. Dividend pay out ratio is
calculated by DPS/MPS*100
Growth (G) – Growth of companies measures the rate at
which a firm is growing. It is one of the determinants of
financial performance of the company. It is calculated by
multiplying retention ratio and ROE.
ANALYSIS & FINDINGS
CORRELATION ANALYSIS
Airtel Ltd. Highly negative correlation is showing that both
companies are enjoying its effectiveness. To maintain
effectiveness and liquidity, dividend policy and profit
earning capacity, they required to manage minimum cost of
capital in a appropriate manner. It is indicating negative
relationship between all three variable.
Cost of Capital and Profitability
The aggregate result suggests that there is relationship
between cost of capital and profitability of the company. The
relationship between the cost of capital and profitability has
been found in the company. A negative relationship is
observed in the company. It is because the profitable
companies are expected to procure the funds with cheaper
cost.
Cost of Capital and Liquidity
In the sector of telecommunication group of industries, the
overall cost of capital and liquidity is negatively related with
each other. This implies that highly liquid companies are
procuring the funds by incurring less amount of cost. On the
other hand less risky companies in terms of liquidity are
spending less amount of money for mobilizing the capital for
their survival and growth. It is theoretically true that the
investors generally prefer to invest their funds in less risky
companies.

Table 2: Corelation Between Cost Of Capital and Other

Variables In Bharti Airtail Ltd.
Variables
cost of capital & profitability (rate of return)
cost of capital & liquidity
cost of capital & dividend
Cost of Capital and Dividend
Correlation In the sector of telecommunication industries, dividend
becomes the significant factor of the cost of capital. In this
– 0.6989937
sector the dividend is negatively related with the cost of
– 0.4535332 capital. The negative coefficient of the payout variable
suggests that investors have preference for current dividend.
– 0.2110172

cost of capital & growth 0.60518738

Pearson’s Correlation Coefficient
Analysis
Pearson’s Correlation analysis is used to find the relation
among various variables i.e. cost of capital and profitability
cost of capital and liquidity, cost of capital and dividend, cost
of capital and growth,. One variable cause, is an independent
and another variable result, will be a dependent variable. By
using these ratios relationship between these data can be
measured. There is a negative relationship between first,
second and third but positive with forth variable.
Table 3- It is showing positive negative relation between cost
of capital and liquidity, profitability and dividend in Bharti
Cost of Capital and Growth
The aggregate result suggests that correlation between the
costs of capital and growth is significant. The cost of capital
of diversified companies is declining with the growth of the
companies because of constant growth of profit of the
companies has minimized their expenses and cost and
increase in their loan and fund collecting capacity is at low
interest rate.
findinG of tHe study
It was found that the cost of capital of company vary with
fluctuations in other factors due to variation of nature of
 Cost of Capital And Profitability Analysis (A Case Study of Telecommunication Industry) 47
industry. The study observed among the variables of
financial performance; growth and profitability become
significant factor of affecting cost of capital. The existence
of negative relationship between cost of capital and
profitability indicating the cost of capital have negative
impact on profitability of the companies. With the increase
of cost of capital, profit of the companies will automatically
fall.
The cost of capital of the company is positively related with
the growth of company implying cost of capital are
increasing because of constant growth of company in its
growing stage as more fund is used for growth.
The cost of capital is negatively related with the dividend
whereas dividend is positively related with the cost of capital
for Telecommunication sector. The positive relationship
signifies that the investors have no preference for current
dividend in general.
In this study, liquidity is taken for measuring the risk of the
companies from the point of view of shareholders investment
concerned. It has been observed the cost of capital is
negatively related with liquidity in the company. It implies
less risky companies that is keeping larger amount of funds
in form of liquidity is and able to procure the funds at cheaper
cost.
ConClusion
The study has analyzed there is significant relationship
between cost of capital and the efficiency, profitability,
dividend policy, growing capacity relationship of
Telecommunication industry in India; some of the important
ratios were used to measure the financial performance of
these companies. Based on the above analysis the significant
negative relationship is found between two variables other
than growth and cost of capital.
The overall cost of capital is affected by the designing of
capital structure of Indian industries. Therefore, maintenance
of optimum level of capital structure irrespective of nature of
industries is mandatory for a firm. Hence, the corporate
executive should give due attention for attaining optimum
level of capital structure for sustainable growth of the firm.
The optimum level of capital structure depends on nature of
each industry. The change of cost of capital affects the
company’s profitability position. Again the lower cost of
appendiX
Balance Sheet of Bharti Airtel
Mar ‘10 Mar ‘09
12 mths 12 mths
capital positively affects the profitability position of the
companies.
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Mar ‘08 Mar ‘07 Mar ‘06 Mar ‘05
12 mths 12 mths 12 mths 12 mths
48 Journal of Commerce & Accounting Research Volume 1 Issue 4 October 2012

Sources Of Funds
Total Share Capital 1,898.77 1,898.24 1,897.91 1,895.93 1,893.88 1,853.37
Equity Share Capital 1,898.77 1,898.24 1,897.91 1,895.93 1,893.88 1,853.37
Share Application Money 186.09 116.22 57.63 30 12.13 2.72
Preference Share Capital 0 0 0 0 0 0
Reserves 34,650.19 25,627.38 18,283.82 9,515.21 5,437.42 2,675.38
Revaluation Reserves 2.13 2.13 2.13 2.13 2.13 2.13
Networth 36,737.18 27,643.97 20,241.49 11,443.27 7,345.56 4,533.60
Secured Loans 39.43 51.73 52.42 266.45 2,863.37 3,959.88
Unsecured Loans 4,999.49 7,661.92 6,517.92 5,044.36 1,932.92 1,034.41
Total Debt 5,038.92 7,713.65 6,570.34 5,310.81 4,796.29 4,994.29
Total Liabilities 41,776.10 35,357.62 26,811.83 16,754.08 12,141.85 9,527.89
Mar ‘10 Mar ‘09 Mar ‘08 Mar ‘07 Mar ‘06 Mar ‘05
12 mths 12 mths 12 mths 12 mths 12 mths 12 mths
Application Of Funds
Gross Block 44,212.53 37,266.70 28,115.65 26,509.93 17,951.74 13,240.63
Less: Accum. Depreciation 16,187.56 12,253.34 9,085.00 7,204.30 4,944.86 3,475.64
Net Block 28,024.97 25,013.36 19,030.65 19,305.63 13,006.88 9,764.99
Capital Work in Progress 1,594.74 2,566.67 2,751.08 2,375.82 2,341.25 994.46
Investments 15,773.32 11,777.76 10,952.85 705.82 719.7 931.9
Inventories 27.24 62.15 56.86 47.81 17.74 31.58
Sundry Debtors 2,104.98 2,550.05 2,776.46 1,418.52 1,076.17 715.74
Cash and Bank Balance 54.89 153.44 200.86 239.11 201.81 174.96
Total Current Assets 2,187.11 2,765.64 3,034.18 1,705.44 1,295.72 922.28
Loans and Advances 7,072.42 5,602.83 5,103.13 3,160.02 1,937.54 1,354.85
Fixed Deposits 761.86 2,098.16 302.08 541.35 105.61 209.17
Total CA, Loans & Advances 10,021.39 10,466.63 8,439.39 5,406.81 3,338.87 2,486.30
Deffered Credit 0 0 0 0 0 0
Current Liabilities 12,979.55 13,832.49 12,400.38 9,809.83 6,735.36 4,458.80
Provisions 658.75 634.4 1,961.95 1,232.84 537.44 249.32
Total CL & Provisions 13,638.30 14,466.89 14,362.33 11,042.67 7,272.80 4,708.12
Net Current Assets -3,616.91 -4,000.26 -5,922.94 -5,635.86 -3,933.93 -2,221.82
Miscellaneous Expenses 0 0.09 0.2 2.66 7.94 58.35
Total Assets 41,776.12 35,357.62 26,811.84 16,754.07 12,141.84 9,527.88
Contingent Liabilities 3,921.50 4,104.25 7,140.59 7,615.04 4,740.34 3,017.26
Book Value (Rs) 96.24 145.01 106.34 60.19 38.71 24.44
Ratios of Bharti Airtel company
Ratios

Mar ‘ 06 Mar ‘0 7 Mar ‘ 08 Mar ‘ 09 Mar ‘ 10

Per share ratios

 Cost of Capital And Profitability Analysis (A Case Study of Telecommunication Industry) 49

Adjusted EPS (Rs) 10.62 21.27 32.9 40.79 24.82

Adjusted cash EPS (Rs) 31.57 36.26 38.03 36.96 35.25

Reported EPS (Rs) 10.62 21.27 32.9 40.79 24.82

Reported cash EPS (Rs) 31.57 36.26 38.03 36.96 35.25

Dividend per share -- -- -- 2 1

Operating profit per share (Rs) 21.32 38.28 56.16 69.5 36.65

Book value (excl rev res) per share (Rs) 38.71 60.19 106.34 145.01 96.24

Book value (incl rev res) per share (Rs.)

Net operating income per share (Rs) 59.45 94.16 135.73 179.37 93.77

Free reserves per share (Rs) 28.11 49.88 83.18 121.78 84.64

Profitability ratios

Operating margin (%) 35.86 40.65 41.37 38.74 39.08

Gross profit margin (%) 23.14 27.47 29.08 29.33 28.15

Net profit margin (%) 17.8 22.46 23.99 22.58 26.36

Adjusted cash margin (%) 31.57 36.26 38.03 36.96 35.25

Adjusted return on net worth (%) 27.42 35.23 32.04 33.74 23.27

Reported return on net worth (%) 27.47 35.35 30.94 28.13 25.79

Return on long term funds (%) 21.28 29.83 28.52 29.01 24.36

Leverage ratios

Long term debt / Equity 0.61 0.43 0.3 0.26 0.12

Total debt/equity 0.65 0.47 0.33 0.28 0.14

Owners fund as % of total source 0.65 0.47 0.33 0.28 0.14

Fixed assets turnover ratio 0.72 0.75 1.03 1 0.88

Liquidity ratios
Current ratio 0.44 0.47 0.57 0.69 0.68

Current ratio (inc. st loans) 0.44 0.47 0.57 0.69 0.68

Quick ratio 0.45 0.47 0.55 0.65 0.72

Inventory turnover ratio 634.52 373.35 453.06 547.83 1,307.05

Payout ratios

Dividend payout ratio (net profit) -- -- -- 5.73 4.71

Dividend payout ratio (cash profit) -- -- -- 3.99 3.28

Earning retention ratio 100 100 100 95.22 94.78

Cash earnings retention ratio 100 100 100 96.5 96.48

Coverage ratios

Adjusted cash flow time total debt 1.34 0.82 0.66 0.61 0.4
50 Journal of Commerce & Accounting Research Volume 1 Issue 4 October 2012

Financial charges coverage ratio 17.22 26.09 27.77 30.93 49.64

Fin. charges cov.ratio (post tax) 16.08 24.13 25.6 26.63 48.73

Component ratios

Material cost component (% earnings) 0.47 0.29 0.16 0.84 0.78

Selling cost Component 7.14 6.3 7.15 6.49 6.75
Exports as percent of total sales 0.47 0.29 0.16 0.84 0.78
Import comp. in raw mat. consumed -- -- -- -- --
Long term assets / total Assets 0.72 0.75 1.03 1 0.88
Bonus component in equity capital (%) 82.7 82.61 82.53 82.51 82.49